Question:

I have been reading in the newspaper about a tax case “Penny & Hooper” which has got me worried. It seems that the people in Penny & Hooper have been penalised by the IRD for using a structure that is common in New Zealand, and that I am using myself!

Answer:

Recently there has been a lot of coverage in the mainstream news about “Penny & Hooper”, a case that has been heard in the Supreme Court and which has application to the way that many small businesses, including pharmacies, are structured.

The case concerned two orthopaedic surgeons who had been trading as sole traders and, then (prior to the top tax rate being raised from 33% to 39% in 2001), began trading through a company structure.

The companies were owned by the surgeons’ family trusts.

The reason the case has attracted so much attention is because the IRD has succeeded in the highest court in New Zealand in challenging a structure that has become almost the norm for small businesses here.

On the face of it, this case will cause great concern to many pharmacists for a number of reasons.

Many pharmacies are structured with a combination of company and trust ownership (with some differences from other kinds of business due to the Medsafe requirement to have majority ownership by a pharmacist).

There has been alarm expressed in various publications about the uncertain position that business owners have been placed in as a result of the decision.

However, for most pharmacy businesses, the risk of adverse tax consequences from this decision is low. The reasons for this are outlined in more detail below.

A different situation compared with pharmacy

The argument from the IRD is centred on the use of the company and the trust structure as a way of diverting income from personal services.

The contention, which the court agreed with, was that the arrangement to restructure a company and pay a PAYE salary to the surgeons was an arrangement which was made to avoid tax.

From a quick look at the facts of the case, there are a few key differences from your average pharmacy.

Mr Penny and Mr Hooper were earning very high incomes prior to the company restructure.

After the restructure, their companies paid Mr Penny and Mr Hooper salaries in the region of $100,000 per annum. Arguably, Mr Penny and Mr Hooper would not have accepted employment at that level of salary in a transaction with an unrelated party.

Also, the income earned by the surgeons was mostly related to services provided by the surgeons.

This set of facts is obviously different for most pharmacies. Although the company and trust ownership structure is often similar, the income of a pharmacy is not dependent on the personal exertion of the pharmacist to the same extent that income is for a surgeon.

The income generated in a pharmacy comes from a variety of sources. A pharmacist’s labour forms only a part if the overall offering.

Usually a pharmacist, who has a similar business structure to the doctors in Penny & Hooper, will be paid by their companies about the same as they would be if they had accepted employment through an unrelated party.

There are still lessons for pharmacy from the case

Even though the facts of this case are unlikely to be directly applied to most pharmacy businesses, there are some key lessons for pharmacy owners:

Business owners should be careful when entering into any business transaction where reducing the level of tax is of more than an incidental motivation.

Shareholders working in their own companies should pay themselves a salary that is equal to what they would receive if they were employed on an arm’s length basis.

The case highlights how far back the IRD will go, when investigating taxpayers.

The IRD is now on a roll after having won several high profile tax avoidance cases.

In general, now is not the time to be engaging in transactions which might be viewed as high risk.

You have been warned!

Published by Atul Mehta, Markhams Auckland in Pharmacy Today October 2011